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Policy Instrument Pathways and their Ability to Deliver Low-Carbon Infrastructure in the EU

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This presentation will focus on the results of a paper assessing the ability of three stylised policy scenarios to deliver the low-carbon energy infrastructure required in the EU by 2050. First, key infrastructure requirements as commonly agreed by modelling studies will be outlined across the key sectors of power generation, industry, buildings and transport, with ‘infrastructure’ encompassing both stationary and mobile components of the energy system (from power generation to vehicles). The three stylised scenarios will then be introduced, each centred on a particular policy paradigm (market-based, technology-based and behaviour-based). Following this, the key benefits and problems associated with each, and their ability to deliver the energy infrastructure outlined for each sector, will be presented.

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Dealing with uncertainty in the European climate policy

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While the European climate policy has been the target of a large number of economic analyses, both from academics and from the European Commission services, almost all modelling exercises have been deterministic, allowing at best for testing a few scenarios. Stochastic models have been developed but in most cases without numerical application to climate policies. In the few exceptions, the climate policy only consists in CO2 pricing, implemented either through a tax, an ETS or a rate-based policy (e.g. an intensity target).

Yet the history of climate policy is full of surprises, including the swings in EU ETS allowance price and the unexpected surge in PV installation in Germany. We develop a simple stochastic model of the European energy sector featuring the most important uncertainty sources in this context, i.e. economic growth and the cost of key technologies, as well as the interaction between climate policy and renewable energy subsidies.

It turns out that uncertainty changes the (ex ante) optimal policy choice. In particular, most analysts conclude that if CO2 emissions from the power sector are covered by an ETS, there is no or little rationale for renewable energy subsidies. Yet, if uncertainty is high enough, emissions may fall below the ETS cap in some states of the world, leading to a nil allowance price. Hence, energy subsidies at a proper level are justified as a kind of insurance that at least some abatement will happen in these states of the world, which is welcome since the marginal benefit of GHG abatement is positive in these states of the world also.

This point is not only theoretical: a careful examination of existing and past ETS worldwide indicates that for most of them, emissions have been significantly below the cap during at least a part of their history. Moreover there is no guarantee that the Market Stability Reserve proposed by the European Commission will be adopted by the Council and the Parliament, and most analyses conclude that this mechanism is unlikely to stabilise the CO2 price significantly.

Moreover, we show that the design of renewable energy subsidies should take into account uncertainty. In particular, feed-in-tariff, premium and renewable quota all respond in a specific way to a change in renewable energy cost, in fossil fuels price or in electricity demand. A model is designed to compare them when implemented in isolation, which concludes that a renewable quota is by far the worst instrument, mostly because it does not respond to a change in renewable energy cost or in fossil fuels price. Finally, we analyse how this ranking of renewable subsidy instruments changes when they are implemented together with an ETS, as is currently the case in the EU. Compared to the premium, the feed-in-tariff provides a subsidy which decreases with the electricity price, itself positively correlated to the CO2 price. Hence it helps to stabilise the marginal abatement cost, which is welcome for a stock pollutant like GHG gases, whose marginal benefit curve is flat.

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The macroeconomic setting is slowly moving towards financing the green / low carbon economy with diversified private and public oriented sources. Nevertheless, if compared to the mass of potential liquidity this development is still in its infancy.

Sector, firm based and macro evidence is presented and integrated.

We do highlight three key findings among others.

At firm level, the overall evidence could reinforce the likelihood of a different kind of scenario, where MNEs proactively react to the recession shock and LC economy targets and find ways to bring together competitiveness and sustainability; SME react with more difficulty, some of them ‘exploiting’ the challenge of financial barriers and (environmental) policies by turning costs into enhanced innovative and economic performances, others failing to innovate. If this is on the one hand a typical and also normal evolution of the economic cycle which depends upon firms’ creation and destruction, policy makers should be aware of the possible increasing divergences between sectors, firms, regions in the EU; some of those could possess irreversible features and create ‘hot spots’, namely structurally underperforming regions / sectors.

Second, financial barriers confirm to be a deterrent for the innovative capacity of EU firms in the current situation, if observe the overall quanti-qualitative evidence. This is true for the economy as a whole, and for manufacturing or construction firms taken alone. Being smaller and having low human capital in the firm also hampers environmental innovations (EI). On the ‘positive’ side, we note that existing regulations and expected increasing demand for green products support EI adoption. Financial barriers are perceived by firms and influenced by technological lock in, uncertainty on investments, non-competitive markets, and lack of subsidies. While policies are driving innovations to some extent, ‘external knowledge sourcing’ seems not to play any significant role in this context. This highlights a strong critical issue: external finance elements deters EI and external knowledge is not acting as a potential substitute; firms are currently isolated islands towards the green economy, with respect to other firms and financial institutions.

At macro level, the possibility to use environmental policy reforms is assesses by a dynamic CGE modelling approach that analyzes the case of Green Climate Funds, which are eventually generated out of carbon taxes revenues and might support sector eco innovative dynamics following countries specific needs. Green Climate Funds financed through a levy on carbon can benefit all parties, and larger benefits are associated with energy efficiency in developing countries.

The politics of policy choice. Understanding political feasibility of climate policy instruments in the EU

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The EU has adopted a mix of policy instruments to achieve its carbon emission reduction targets. However, market and governance failures have led to major inefficiencies, and many call for a revision of the existing instrument mix. But what policy options are politically feasible? Political feasibility is still poorly understood, and the literature falls short in definitions, methods and empirical studies. In this paper we advance the current state of knowledge by developing a systematic framework that integrates 3 key dimensions of political feasibility, namely power dynamics among relevant interest groups, their preferences for policy instruments and the institutional setting in which proposals for instruments are discussed. The study provides novel insights into the relationship between these dimensions and the political feasibility of different typologies of instruments in the context of the EU climate policy. The empirical analysis is based on a multi-method approach that includes interviews, focus groups, an on-line survey and a policy simulation with relevant stakeholders.